Some economists are skeptical about microfoundations

Economists seem to rely heavily on a sort of folk psychology, a relic of the 1920s-1950s in which people calculate utilities (or act as if they are doing so) in order to make decisions. A central tenet of economics is that inference or policy recommendation be derived from first principles from this folk-psychology model.

This just seems silly to me, as if astronomers justified all their calculations with an underlying appeal to Aristotle’s mechanics. Or maybe the better analogy is the Stalinist era in which everything had to be connected to Marxist principles (followed, perhaps, by an equationful explanation of how the world can be interpreted as if Marxism were valid).

Mark Thoma and Paul Krugman seem to agree with me on this one (as does my Barnard colleague Rajiv Sethi). They don’t go so far as to identify utility etc as folk psychology, but maybe that will come next.

P.S. Perhaps this will clarify: In a typical economics research paper, first there’s the utility model with lots of derivatives and integrals, leading to a proof that a certain parameter of interest can be estimated using some sort of regression model. The second step is to fit the regression. When I’m talking about the emptiness of classical microfoundations, I’m saying you can just go straight to the regression, maybe do the utility analysis afterward to help understand things, but it’s not foundational.

P.P.S. I’m a big fan of utility analysis as a normative theory; I’ve published several research articles using utility theory and devoted a chapter of Bayesian Data Analysis to the topic. But I don’t think utility theory is a good foundation for a model of human behavior. Again, I’d rather model prices etc directly without attempting to found such models on this obsolete model of human psychology. And, yes, this reliance on utility theory leads to widespread confusion. Consider the silly belief that many people seem to hold, that a dislike of uncertainty corresponds to a nonlinear utility function for money.

45 Comments

Andrew, with respect, this is completely wrong. It’s true that many economists misunderstand methodological individualism — the justification for microfoundations — but the problems have nothing to do with the caricature of “utility maximization” you describe. The arguments go back to Weber and include fundamental works by Schumpeter, Hayek, and more recently folks like Jon Elster. Methodological individualists hold that social science — not, it should be emphasized, natural science — depends on causal explanations for macro-level phenomena that are traced to the preferences, beliefs, and actions of individual agents. (Whether these are described with the 19th-century metaphor of utility maximization is another issue entirely.) Lots of discussion here: http://organizationsandmarkets.com/?s=microfoundations

The concept of microfoundations is fine—indeed, in some sense, essential. But the particular model of utility functions etc. is folk psychology that’s been superseded by decades of research into real psychology. Economists seem to persist in seeing real psychology as some sort of tweak on utility theory, but it’s not a tweak, any more than the periodic table of the elements is a tweak on the four elements of earth/air/fire/water.

Economics—supply and demand, the study of prices, the normative study of optimization, etc.—is still valid. But, no, I don’t think utility microfoundations is foundational at all. Folk psychology isn’t completely wrong but it’s not much of a foundation, especially now that we know so much real psychology.

Peter G. Klein with all respect you are totally completely 100% wrong and Andrew is 100% right. when our reliance on the assumption that agents are rational utility maximisers is criticized we do argue that what we really rely on is methodological individualism. But when we are not challenged, we rely on rational utility maximizers. That is only part of the problem. It is also standard to assume that people care only about consumption and leisure (so among other things are totally selfish). This assumption is not at all defended, but it is crucial for all of the standard results (for example the idea that with rationality, perfect competition, complete markets and no externalities other than those due to altruism the market outcome is Pareto efficient).

Furthermore, econonomists have abandoned methodological individualism. The central concept of economic theory is now Nash equilibrium. We work on implications of the assumption that the world is in Nash equilibrium. This assumption is absolutely inconsistent with methodological individualism which has been totally abandoned and rejected by mainstream economic theory. Of course most economists claim they rely on methodological equilibrium, but they are totally wrong. This is not a matter of legitimate dispute.

Finally, your comment is off topic. The first word in the quote from an old post is “Economists.” You bring up Weber and Elster who aren’t economists. A statement about economists is not “completely wrong” because it is not a true statement about a sociologist and a philosopher. Also, by today’s standards, Schumpeter and von Hayek’s works would not be publishable as economic research.

Andrew,
did you read the world’s most famous psychologist’s book “Thinking, fast and slow”? You are just calling his central contribution of prespect theory folk psychology, since it can easily be formulated in terms of a utility function.

But maybe you know more about the connection between psychology and economics than does Damniel Kahneman.

I am a big fan of Kahneman; see, for example, here. The work of Kahneman, Tversky, and others in the “judgment and decision making” field fits within a long tradition of psychophysics that I very much respect, of forming better mathematical models for cognition and behavior. Their models are indeed connected with utility functions (although not the same as classical utility theory, as they violate the classical axioms). Their experiments are inspired by various common-sense ideas but that does not make them folk psychology.

The foundation of folk psychology seems only relevant in basic models of microeconomic choice and behavior. For instance, Kreps in his popular graduate level Microeconomics book notes that it’s trivially true that people don’t consult utility functions to choose behavior; rather, they tend to behave *as if* they do. The mistake that I often see the economists you cite make is that they seem to purport that paper authors suggest generality beyond that which is allowed by their model’s assumptions. Doing so is obviously misleading.

Do most, if not all, organisms behave *as if* they have utility functions?

A major problem is that many utilitarian models do not, and will never, have an empirical basis. For a heavily applied subject like economics (where even the most theoretical papers have policy recommendations) this situation is rather strange. Economic theory should be built upon observation and theories which can be tested (all the most interesting economic theories are btw).

I think the main issue here whether the dominance of methodological reductionism in macroeconomic research is justifiable. And this is independent on whether the utility function theory (or the preference relations) is a useful framework for the study of individual behaviour. The question is: Can we gain a better understanding macroeconomic phenomena by studying economic behaviours on finer scales (lower level)”. If macroeconomics is like biology the answer in probably not. Higher level phenomena are not always deducible from lower level theories. And the reason for that is complexity and accident.

It takes a model to beat a model. Do we really know a lot of psychology? Psychological insights are often the result of controlled experiments and it’s hard to generalize from those results. More importantly, it’s rare to find psychologist that even try to write a theory paper that puts together many of the empirical findings in a consistent theoretical framework. When one is found, like Kahneman, he wins the Nobel prize. Perhaps it’s not economists’ fault then. In fact, several important economists try to generalize from both pure psychological and behavioral economic experiments (see papers like Optimal Expectations by Brunnermeier and Parker, or Reference-Dependent Consumption Plans by Koszegi and Rabin, or Salience Theory of Choice under Risk by Bordalo-Gennaioli-Shleifer). If we like to believe that individuals make decisions at all (free will and the like) there has to be some well defined objective function to maximize, no matter how constrained. Often economic models neglect some aspect of reality to focus on some other. You could say “all corporate finance is bogus because most models have risk-neutral agents”. And yet with this very primitive characterization of the objective function you can get a lot of useful insight, both positive and normative. Why? because we are modelling situations where risk is a second order concern.

Andrew’s pejorative use of the term “folk psychology” is idiosyncratic and misleading, at least to this philosopher’s ears.

The standard uses of “folk psychology” in both philosophy and psychology do not carry negative connotations. For psychologists, folk psychology is another name for “theory of mind,” the implicit rules by which we make inferences from behavior to what other people are thinking. For philosophers, folk psychology is the commonsense picture of our minds as characterized largely by propositional attitudes (beliefs, desires, intentions, and the like), as opposed to, e.g., connectionist pictures of our minds as characterized purely by information-processing systems.

Never (a few eliminative materialists aside) do psychologists of philosophers use “folk psychology” to refer to outdated or “amateur” theories that ought to be replaced by “real psychology.”

Indeed, not only is folk psychology perfectly acceptable, but philosophers at least will consider *any* theories of human behavior that appeal to propositional attitudes like belief and desire to be couched in terms of folk psychology. Leaving folk psychology behind would require couching the microfoundations of economics in terms of Bayesian or connectionist or whatever theories of mind… Surely that’s not an appealing prospect. For more detail see here: http://plato.stanford.edu/entries/folkpsych-theory/

That said, I’m very sympathetic to Professor Gelman’s claim that much contemporary economics is based on false empirical assumptions about how people tend to behave. A classic early statement of the conceptual (as opposed to empirical) problems with expected utility theory is Sen’s “Rational Fools” paper.

This issue is in finance too. One of the biggest, and certainly loudest, critics of microfounded finance models is Robert Haugen. Haugen now runs an investment services firm, but he was previously a finance professor at University of California, Irvine, and is #17 on a publications’ prestige weighted list of finance’s most prolific authors, 1959 — 2008.

Haugen’s criticism is that the aggregate of very complicated, highly interacted, micro behavior can be better understood if you just observe the behavior of that aggregate, rather than trying to understand it, predict it, and make good policy from modeling micro unit behavior and then aggregating up.

In Haugen’s own words:

Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence… (“The New Finance”, 2004, 3rd Edition, page 122)

How then to understand and predict the behavior of an interactive system of traders and their agents?

Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

Aggregation will take you nowhere.

Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro… (page 123)

Square peg, round hole. It’s very hard to find a model where every single person has perfect maximization and perfect rational expectations, and you still get, at least qualitatively, the type of aggregate behavior we see in the real world, because that aggregate behavior we see in the real world is not generated from individuals who all have perfect maximization and perfect rational expectations, not even close for many things. You’re trying to fit perfect optimizing behavior of individuals (“internal consistency”) to the behavior of aggregates that did NOT, in fact, result from perfect optimizing behavior of individuals. They resulted from very imperfect optimization of very imperfect individuals, with very limited expertise, information, time for analysis, and self-discipline, to name a few.
For more on this see:

Here’s an economist’s viewpoint. The parameters of interest are some functional of data’s distribution. You’re saying “I don’t like the functionals economists use, they presuppose rational agents etc”. Fine, so specify a different model including psychological biases and come up with a different set of parameters of interest and a different functional. I’m completely on board with that – sometimes it will make sense to incorporate psychological biases into the modelling (although sometimes the rational model actor is adequate, I hope you’ll grant! It all depends on the question at hand).

Here is where we part company. You’re saying just do the regressions. But the point is that the mapping between the regression coefficients and the underlying parameters we’re interested in might not be trivial. So we might have to do all the preliminary business you disparage above. This is completely auxillary to the question to whether people are rational or not. If we have a model of non-rational behaviour, we’d still have to do this step, to understand how the model parameters are identified.

It seems like you’re conflating two things. Estimating a “structural” model of behaviour is not necessarily estimating a rational agents structural model of behaviour. Indeed there is much work in behavioural economics on estimating structural models in which agents don’t behave rationally. I’d be interested to hear your take on this style of work.

Models are concise description of the data. A rational agent model does a great job. Psychology tells us that the residuals are predictable, they’re not just noise but reflect heuristic in biases in human cognition. That doesn’t make the rational agent model useless.

As the stake raise, one would expect the noise likely gets smaller. So rational agent model is likely poor at modelling how we choose a brand of soap among competing brands that differ by $1, but very good at explaining why the price for different brands are soap are likely to differ by less than $1.

Indviduals are not utility maximizers, or better posed, do not try to maximize utility?

Then explain that when you make decisions that you do not try to make the best choice you can under the circumstances — limited income, information, time, etc and that you are indifferent to the outcomes, or that you try to do as badly as you can.

Kahneman shows how cognitive biases may lead to wrong or inconsistent choices, but he does not jettison utility theory.

Utility theory is much more than simply that people try to make the best choices that they can (or, even more tautologically, that people do what they do). In utility theory, preferences and utilities of outcomes are assumed to exist independently of how the outcomes have come about.

Well, you stated: “But I don’t think utility theory is a good foundation for a model of human behavior.”

This was the motivation for my comment. Unless you can convincingly refute my statement: “Then explain that when you make decisions that you do not try to make the best choice you can under the circumstances — limited income, information, time, etc and that you are indifferent to the outcomes, or that you try to do as badly as you can”, then it does seem a good (but incomplete) foundation.

All I was doing is making a statement of the intuition of decision making, and I have yet to find anyone who will state for the record that they do not try to do the best they can when they make decisions. If that is not maximizing some objective function (a.k.a. utility) subject to a constraint, please enlighten me. And for those who manifestly make serial bad decisions, well, we try to send them for professional help.

The growing field of neuroeconomics is overtly supportive of the basic, but incomplete, utility maximization model. Paul Glimcher at NYU, one of the founders of this line of inquiry, himself states that the economic characterization is basically correct, just incomplete.

Consider the analogy to epicycles. Planets move in predictable orbits, and epicycles are a model of predictable orbits. There’s not much correspondence with the physics, though. Similarly, people make decisions, and utility theory is a model of decision making. I don’t think it’s such a good model, though.

You may find Rabin and Thaler’s 2001 paper in the Journal of Economic Perspectives provides a nice example of the sort of behavior that gets tricky to justify using EU maximization. To steal their thunder a bit, it’s worth considering the following question:

Suppose Johnny is a risk-averse expected utility maximizer, and will always turn down a 50-50 gamble of losing $10 or gaining $11. From this description alone, we can ask what other bets Johnny must turn down (remember– the EU bit of this).

It turns out that if Johnny turns down the bet above, he’ll turn down ANY 50-50 bet were he stands to lose $100 regardless of the upside. That is, he must turn down a bet where stands to win $1 Million on heads, and lose $100 on tails… crazy, right?

The idea is that in order to make sense of small-stakes risk aversion, we’ll do MUCH better to rely on something other than the curvature of utility function for final states of wealth.

I agree that this result is pretty unexpected. The slight problem with the formulation you’ve got here is the claim that the LHS is non-increasing in x; in fact, the LHS is increasing in x, but the marginal increase is so abysmally small that it will never reach the value of u(w). If this seems weird, it’s because reasoning about risk preference using only the utility of final states of wealth based on small-stakes gambles gives crazy predictions about large-stakes gambles.

When I first heard about this result, I was really skeptical too (no one would ever turn down the latter gamble!)– this just means, though, that sitting down to work through the example is that much more important.

Andrew is definitely right to correct the citation of this result– (his paper, obviously predating Rabin and Thaler’s 2001 version, nicely highlights exactly this same perversity).

To get a bit more into exactly why the example works, check out pgs. 221-223 of the article I’ve cited– R&T make the math relatively painless considering the power of the result–

‘When I’m talking about the emptiness of classical microfoundations, I’m saying you can just go straight to the regression, maybe do the utility analysis afterward to help understand things, but it’s not foundational.’

Given comments made previously I presume when you say theories/models that have ‘gone beyond’ rational choice you’re referring to ‘real psychology’. If that’s the case I think it’s fair to ask is the reason you think these theories/models are better because they’re more general and/or predictive? And are these theories/models deductive or inductive?

If they’re are more general/predictive then maybe economists should adopt them and throw out rational choice. However, If they are inductive theories how do you address the critiques laid out in the post I linked to above?

A quote from John Quiggin that I think is relevant: ‘Any consistent pattern of choice among objects (of any kind) that we can observe, can be represented as optimization, that is, as the maximization of a function. The classic version of this result was proved by Cantor, who gave us the modern idea of a function as a mapping between sets, and cleared up a lot of the technical puzzles about continuity and so on. Even choices that are inconsistent in various ways can be represented by more general notions of optimization. So, it makes no sense either to claim (as a lot of economists do) that the fact that we can represent action as the maximization of some “objective” function proves anything positive about the way people think or to object (as a lot of non-economists do) to representing choices in terms of optimization. To (ab)use an apposite quote – this isn’t class warfare, it’s math.’

Quiggin is very mistaken about Cantor though. Cantor was not the origin of the modern idea of a function as a mapping between sets. That honor usually goes to the Bernoulli’s or Euler. They were forced to generalize the idea of a function in that way by the problems they were working on in mathematical physics. The Differential Equations they often worked on lead to discontinuous solutions or ones that today would be represented with delta functions. Cantor’s main contribution was to use the idea of a one-to-one mapping between sets as a way to “measure” the size of infinite sets.

The claim about Cantor clearing up technical puzzles about continuity is pretty weird. That was pretty well done by Cauchy, Weierstrass and all those folks before Cantor. Quiggin is possibly referring to the Continuum Hypothesis, but this has to do with the cardinality of the real numbers, not continuity of functions.

Very much a side issue, but I’ll stand by the claim that Cantor is responsible for set theory in its modern form, and that the key reason set theory is of interest is to allow a rigorous definition of functions. By “puzzles associated with continuity and so on”, I meant to refer to questions such as whether a lexicographic preference ordering can be represented by a continuous function, which I would associate with Cantor rather than with the epsilon-delta methods of Cauchy Weierstrass. If there’s a proof of the representation result that doesn’t use Cantor-style set theory, I’d be very interested to see it (not meant as a snark, I’d really be interested).

No real disagreement John. Cantor is the inventor of set theory in its modern form and it’s interesting to know that Cantor was the originator of that later result, rather than some Economist.

But it would be a stretch to say he invented the idea of a function as a mapping between sets. This I believe was well understood by all the greats from about Euler on. He was just formalizing what was already known. Initially, functions were viewed as equations. For example F(x)=2x+4. As the great mathematicians were solving the differential equations of physics however, they were constantly running into solutions which couldn’t be written down as nice equations like this (“nice” in the sense that was traditional at the time). So they had to think harder about what a function in general was in an abstract sense. Euler might have been surprised by Cantor’s notation and goals, but not this particular idea.

Also all those people working complex numbers, group theory, linear algebra, and modern algebra by mid 1800s clearly understood functions as a mapping between sets in an abstract way. Grassmann for example was publishing his Grassmann algebra stuff before Cantor was born.

Please note that my comment on utility maximization as “doing the best one can under the circumstances” did not include comments on the certainly knotty and central issues of the many dimensions to choice, such as expected utility, hyperbolic discounting and others. It just treats the overall question of whether optimization seems appropriate as a way to describe human choice. Glimcher thinks so. It is clear to me that putting the correct meat on these bones will depend on the findings in psychology and neuroscience.

But as I said, I have yet to find anyone who can show me that he, she or we do not try to make the best possible decision given the constraints. Counter arguments and examples welcome.

A little background on the view – two things came together more or less about the same time that led me to formulate it.

For years I debated with my brother-in-law, a political scientist, whether the utility maximization hypothesis was empty or not — specifically, a tautology. I never really had a convincing reply to his taunts, at least not convincing to him.

At the time, I was looking for an accessible statement of the basic ideas of neoclassical micro theory to give to my intermediate micro theory students, as the text really said little. I happened upon a nice little essay by the mathematical economist Roy Weintraub, He was also associate editor of History of Political Economy at Duke.

I said to him what I wrote on this blog, and he immediately became silent – being very competitive, he is not one to say that I am right – but has never raised the issue again. So I knew I was on to something. Glimcher’s first book on neuroeconomics simply confirmed this.

The part that set off the light in Weintraub’s essay was this: “ The neoclassical vision thus involves economic “agents,” be they households or firms, optimizing (doing as well as they can), subject to all relevant constraints”.

You can see that I have simply rephrased this, so there is no originality on my part. And Weintraub was not really saying anything new, but his particular turn of phrase was just what I needed. The rephrasing seems to work quite well in getting the point across.

Mark – thanks for the tip on the Bruni and Sugden piece – I had not seen it.

What do you mean, model prices directly? You could simply assume some functional form or distribution for some good’s price (as they do in finance). But then you have no explanation of why some goods are higher or lower priced than others. You could say, supply and demand. But what explains demand? Ultimately, you’re going to have to explain why people want good X, which is utility or something like it.

Mathematical models of behavior and cognition are fine. I just think it’s silly for these models to be based on an 80-year-old notion of utility, given that thete’s been a huge amount of psychology research done since then.

[…] Psychology And Economics Posted on March 8, 2012 by reflectionephemeral Andrew Gelman recently referred to an old post of his: Economists seem to rely heavily on a sort of folk psychology, a relic of the […]